Cozy Stress Tests Fail Confidence Test

By Joe Ortiz

Reuters

Traders watch as the results of the European banks stress tests are announced on the floor of the New York Stock Exchange.

The stress tests on European banks were too cozy, did not use sufficiently tough benchmarks and, as a consequence, are unlikely to have the desired effect of normalizing the short- and longer-term funding markets for European banks.

The decision by the authorities to set the benchmark at Tier 1 capital of 6% under a stressed scenario is a huge own goal and an appalling admission of what little progress has been made since the financial crisis struck in 2008.

Indeed, only seven out of 91 banks have failed the stress test, but what’s key is that, collectively, the system needs only €3.5 billion to be declared fit. That’s a far cry from the $75 billion that U.S. banks were forced to raise following the U.S. stress test last year and significantly short of what most analysts were expecting.

Setting the level of capital required in the stressed scenario is fundamental. The stress test carried out last year in the United States, commonly attributed with providing a hefty stimulus to the health of financial markets, placed hefty emphasis on Tier 1 common capital, more usually called “Core Tier 1″ in Europe.

As the U.S. Federal Reserve commented last May:

“The emphasis on what is termed ‘Tier 1 Common Capital’ reflects the fact that common equity is the first element of the capital structure to absorb losses. Offering more protection to more senior parts of the capital structure and lowering the risk of insolvency.”

Lowering the risk of insolvency is what this is all about. In the U.S. tests, the Fed calculated how much additional Tier 1 common capital would be needed to keep the Core ratio above 4% of risk-weighted assets in the most stressed scenario. Using the 6% Tier 1 capital measure, which includes preferred stock and other hybrid instruments, no U.S. banks failed the Fed’s test at all. But at the 4% Core Tier 1 metric, 10 of the 19 banks tested failed, and in aggregate were seen to be in need of $185 billion of additional capital. After taking into account asset sales and capital restructurings already under way, this was reduced to $75 billion.

Since the financial crisis there has been growing general agreement that in the future Core Tier 1 must be the dominant component of Tier 1 capital, although this has not been calibrated.

Take what the FSA’s Turner Review, a report on the financial crisis prepared for the U.K.’s regulator, said about the matter:

“There is a strong prima facie case that minimum bank capital requirements should in future be significantly above those which have applied in the past. The FSA is already applying a set of guidelines, which imply a minimum Core Tier 1 capital of 4%. A possible future regime might be one in which the minimum Core Tier 1 ratio throughout the cycle is 4% and the Tier 1 ratio 8%.”

The Committee of European Banking Supervisors, which ran the European stress tests, says that the reason it did not use core capital as a benchmark is that there is no agreement within Europe of how Core Tier 1 should be calculated. So, the better part of two years after the financial crisis broke, we are still arguing about definitions.

Perhaps the CEBS should have knocked a few heads together by imposing one. By all accounts, the Basel Committee on Banking Supervision is very close to completing its calibration of the new rules and will present G-20 leaders with a complete package of measures at their summit in November. If that’s the case, then they could have come up with a theoretical Core Tier 1 definition for use in the stress tests. After all, as CEBS was at pains to point out, the stress test was only a “what-if analysis.”

There’s also sure to be plenty of debate about the sovereign debt element of the stress test. CEBS imposed a country-specific haircut where sovereign bonds held by banks in their trading books are marked to market at stressed levels. Bonds that are held in the banking book, which will be held to maturity, do not suffer the haircut. These would only have been affected if CEBS had included a sovereign-debt default scenario. That was never going to happen.

European governments would not have agreed to the possibility of an EU country defaulting being included in the test. If they had, the markets would have undoubtedly jumped to a bearish conclusion and started looking around for victims.

Many market observers still see the possibility of a European government defaulting, however. Such an event would certainly mean that these stress tests are consigned to the trash can of regulatory history where they would then belong.

Even without a default, bankers are less than confident that the tests will have the desired effect of clearing the air in European banking and allowing markets to open up.

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